capital budgeting chapter 11. capital budgeting an introduction the word ‘capital’ means...

Capital Budgeting

Chapter 11

Capital Budgeting An Introduction

• The word ‘capital’ means long-term.• Long-term investments represent sizable outlay of funds.• It is for this reason firms need effective procedures to analyze and

select projects into which they can make long-term investments.• Capital budgeting is the name given to the process of evaluating

and selecting long-term investments.• Firms typically make a variety of long-term investments, but the

most common for the manufacturing firm is in fixed assets, which include property (land), plant, and equipment. These assets, often referred to as earning assets, generally provide the basis for the firm’s earning power and value.


• Capital budgeting is the process in which a business determines if projects having long-term significance (for example building a new plant or buying expensive machinery) are worth pursuing.

• In capital budgeting, we forecast a set of cash flows, find the present value of those flows, and make the investment only if the PV of the inflows exceeds the investment’s cost.

• Capital budgeting decisions include such decisions where investment of money and expected benefit arising from it are spread over a period of more than 1 year.

• Process used by companies for making decisions on long-term projects.


• In an ideal situation a business would like to pursue all projects that seem to enhance shareholder value, however this is not possible.

• Capital budgeting techniques are used to determine which projects will yield the most return over a given period of time.

• Based on the results most profitable projects meshing well with overall company objectives are selected.


• For a financial analyst, capital budgeting is of extreme importance.

• It helps a financial analyst to decide which projects to undertake and which projects not to undertake which in turn decides which direction a company is moving in.

• For instance a company selecting more projects in oil and gas sector and shying away from investing in previously favored sector for instance food and agriculture means in the future the focus of the company will be on oil and gas sector of the economy).

Capital Budgeting Decisions Importance

• Capital budgeting decisions are important for a number of reasons:

1. These decisions involve commitment of a large amount of funds.

2. Capital budgeting decisions are irreversible.

3. In case of a wrong forecast concerning cash inflows or outflows a firm may have to face serious negative consequences.

4. They carry long-term implications.

5. Capital budgeting decision involves two important decisions at once: a financial decision and an investment decision.

6. Capital budgeting decisions have national significance as they determine employment, creation of new job opportunities and economic growth.

Capital Budgeting Process

• The capital budgeting process consists of following steps:1. Identification and evaluation of opportunities.

2. Cash flow estimation

3. Project selection

4. Implementation

5. Follow-up

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Capital Budgeting ProjectsCategories

• Analyzing capital expenditure proposals is not costless—benefits can be gained, but analysis does have a cost. For certain types of projects, an extremely detailed analysis may be warranted, while for other projects, simpler procedures are adequate.

• Accordingly, firms generally categorize projects and then analyze them in each category somewhat differently:1. Replacement Projects– As a firm’s growth slows and it reaches maturity, most capital expenditures will be made to replace or renew

obsolete or worn-out assets• Maintaining the business• Cost reduction

2. Expansion projects– The most common motive for a capital expenditure is to expand the level of operations—usually through

acquisition of fixed assets. A growing firm often needs to acquire new fixed assets rapidly, as in the purchase of property and plant facilities.

– Requires complex decision making3. New products and services– These investments relate to new products or geographic areas, and they involve strategic decisions that could

change the fundamental nature of the business. Invariably, a detailed analysis is required, and the final decision is generally made at the top level of management.

– More complex decision making than both replacement decisions and expansion decisions– High uncertainty4. Mergers– In a merger, one firm buys another one. – The concepts of capital budgeting underlie merger analysis.

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Capital Budgeting ProjectsImportant Terminologies

• Independent vs. Mutually Exclusive Projects– Independent Projects

• For example the decision to replace a company's computer system would be considered independent of a decision to build a new factory.

– Mutually Exclusive Projects• Projects that compete directly with each other (i.e. you

own some manufacturing equipment that must be replaced. Two different suppliers present a purchase and installation plan for your consideration).


• Unlimited Funds versus Capital Rationing– Unlimited Funds

• The availability of funds for capital expenditures affects the firm’s decisions. If a firm has unlimited funds for investment, making capital budgeting decisions is quite simple: All independent projects that will provide an acceptable return can be accepted.

– Capital Rationing• Typically, though, firms operate under capital rationing

instead. This means that they have only a fixed number of dollars available for capital expenditures and that numerous projects will compete for these dollars.


• Conventional versus Nonconventional Cash Flow Patterns • Conventional (Normal) Cash Flow Patterns• A conventional cash flow pattern consists of an initial outflow followed

only by a series of inflows. For example see the figure.


• Non-Conventional (Non-Normal) Cash Flow Patterns• A nonconventional cash flow pattern is one in which an initial outflow is

followed by a series of inflows and outflows.

Capital Budgeting ProjectsCriteria used for accepting or rejecting projects

• Companies use the following criteria for deciding to accept or reject projects:

1. Payback PeriodI. Regular Payback

II. Discounted Payback

2. Net Present Value (NPV)• Net Present Value Profile

3. Internal Rate of Return (IRR)• Multiple Internal Rate of Return

4. Modified Internal Rate of Return (MIRR)• The NPV is the best method, primarily because it addresses directly the

central goal of financial management—maximizing shareholder wealth. • However, all of the methods provide useful information, and all are used in

practice at least to some extent.

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1. Payback PeriodI. Simple Payback Period• Definition• Amount of time it takes for project’s cumulative cash flows to recover the cost (initial

investment) of the project. • The sooner the cost is recovered the better it is.

• Formula

•

• Decision Rule– The length of the maximum acceptable payback period is determined by

management. – If the payback period is less than the maximum acceptable payback period, accept

the project.– If the payback period is greater than the maximum acceptable payback period,

reject the project.

Full recovery year

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1. Payback Period (contd.)• Example 1

Suppose the firm requires cost to be recovered within 3 years.

• Important Questions =>• Which project we would accept?• What if the two projects are mutually exclusive?• What if the two projects are independent?

Cut-off payback period: It is the pre-determined (desired) length of time for an investment to be recovered.

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1. Payback Period (contd.) Concept

What if cash flows are received evenly during the year?• Formula:

Original investment

cash inflows per period

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1. Payback Period (contd.)

I. Simple Payback Period

Advantages1. Easy to calculate.

2. Easy to comprehend.

3. Easy to analyze.

4. Very good indicator of liquidity of a project.

Disadvantages5. All dollars received in different years are given the same weight (i.e., the

time value of money is ignored).

6. Does not consider cash inflows after the original investment is recovered. which implies it is biased against long-term projects that take longer time periods to become lucrative .

7. Sets off unrealistic expectations.

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I. Simple Payback PeriodDisadvantages1. All dollars received in different years are given the same weight (i.e., the time value of

money is ignored).

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I. Simple Payback PeriodDisadvantages2. Does not consider cash inflows after the original investment is recovered which implies it is

biased against long-term projects that take longer time periods to become lucrative .

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Cut-off payback period: It is the pre-determined (desired) length of time for an investment to be recovered.

Class Practice Questions from Book

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II. Discounted Payback Period• Definition: Number of years it takes for project’s cumulative

discounted cash flows to recover its costs.

or

Length of time required to recover original investment from the present value of expected future cash flows.

• Formula:

Years before full recovery + unrecovered cost at the start of the year cash flow during full recovery year

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II. Discounted Payback Period

Advantages1. A more realistic measure than simple pay back period.

2. Takes into account the principle of time value of money (PV of cash inflows taken into consideration).

Disadvantages3. Ignores cash flows beyond cut-off point.

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We calculate the discounted paybacks for S and L assuming that both have a 10% cost of capital. Each inflow is divided by (1 + i)n = (1.10)n where n is the year in which the cash flow occurs and i is the project’s cost of capital; and those PVs are used to find the payback.

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2. Net Present Valuea. Net Present Value (NPV)• Definition: NPV is the present value of cash inflows minus the present

value of cash outflows.• Characteristics• A very important capital budgeting tool.• Helps firm assess the level of importance various capital budgeting

projects have.– Why doing such a thing is important?– Capital budgeting projects normally requires expenditures in millions and

billions of dollars, before embarking on any such project they want to be reasonably sure that the cash inflows generated from the project will pay off project’s costs within a reasonable amount of time.

• Firms generally can carry out multiple projects, capital budgeting tools like NPV help firms choose the best among them.

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2. Net Present Value (contd.)

• Formula:

i. NPV = Present value of cash inflows - Present value of cash outflows• Cash outflows: As on today (PV)• Cash inflows: Discounted back (To find PV)

ii. .

• Decision Criteria (3 scenarios):– NPV = Positive (Cash inflows than outflow) => Accept the project.– NPV = Zero (Cash inflows than outflow) => Indifferent– NPV = Negative (Cash inflows than outflow) => Reject the project.

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• In case of:• Independent projects: NPV > 0 (Accept both projects or all within budget)

• Mutually exclusive projects: Accept the project with highest positive NPV

• Example:• Global Enterprises is considering two projects. Each project requires an

initial outlay of $100,000 and provides the following cash flows. The firm requires a ROR of 10% on both projects.

• Project A: Cash Outflow = 100,000

Cash Inflows: 1st year = 30,000 2nd year = 40,000 3rd year = 50,000 4th year = 60,000

• Project B: Cash Outflow = 100,000

Cash Inflows: 1st year = 40,000 2nd year = 30,000 3rd year = 30,000 4th year = 20,000

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• Remember: For doing NPV analysis always make a timeline.

Advantages1. Adjusts for the TVM.2. Provides a straight forward method for controlling risk of competing projects,

higher risk cash flows can be discounted at higher costs whereas lower risk cash flows are discounted at lower costs.

3. Tells whether the investment will increase firm’s value.4. Considers all the cash flows.

Disadvantages5. May not be considered as simple or intuitive as some other methods. 6. Requires an estimate of cost of capital in order to calculate NPV.7. Expressed in dollar terms, not as a percentage.

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Net present value profile

The net present value profile is the graphical illustration of the NPV of a project at different required rates of return.

Required Rate of Return (%)

Net Present

Value ($)

The NPV profile crosses the hor-izontal axis at the project’s inter-nal rate of return.

The NPV profile intersects the vertical axis at the sum of the cash flows (i.e., 0% required rate of return).

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3. IRR

• IRR stands for ‘Internal Rate of Return’.• Concept:

– IRR quite simply tells you what is the return on a project. – IRR is the discount rate at which NPV of a project is equal to ‘zero’.– When we say NPV of a project is equal to ‘zero’ we mean PV of

cash inflows = PV of cash outflows.

• Definition: • IRR is the discount rate at which PV of cost is equal to PV of

future cash inflows. • It is the rate of return that the firm will earn if it invests in the

project and receives the given cash inflows.

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3. IRR

– We stated, “IRR is the discount rate at which NPV of a project is equal to zero”.

– Using the NPV formula

– In IRR we calculate the discount rate, the ‘r’ at which NPV = 0

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3. IRR

• Decision Criteria• For Independent Projects

IF IRR > cost of capital => accept the project

IF IRR < cost of capital => reject the project• For Mutually Exclusive Projects

Accept the project with highest IRR provided IRR for the project is greater than cost of capital.

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3. IRRAdvantages1. Considers all cash flows of the project.

2. Considers time value of money.

Disadvantages3. Requires an estimate of cost of capital in order to make a

decision.

4. Cannot be used in situations where sign of the cash flows of the project change more than once during project’s life.

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The Multiple IRR problem

• If cash flows change sign more than once during the life of the project, there may be more than one rate that can force the present value of the cash flows to be equal to zero.– This scenario is called the “multiple IRR problem.”– In other words, there is no unique IRR if the cash flows are

nonconventional.

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4. MIRR• MIRR stands for ‘Modified Internal Rate of

Return’.• Definition: MIRR is the discount rate at which the

present value of a project’s cost is equal to the PV of its terminal value where the terminal value is found by summing up the future value of the cash inflows, compounded at company’s cost of capital.

• Formula:

PV costs = Terminal Value

(1+MIRR)n

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4. MIRR

• Decision Criteria• For Independent Projects

IF MIRR > cost of capital => accept the project

IF MIRR < cost of capital => reject the project• For Mutually Exclusive Projects

Accept the project with highest MIRR provided MIRR for the project is greater than cost of capital.

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4. MIRR

Advantages1. Considers all cash flows of the project.

2. Considers time value of money.

3. Eliminates the multiple IRR problem, there can only be one MIRR.

4. A better capital budgeting tool than IRR as it assumes cash inflows are reinvested at the cost of capital.

Disadvantages5. Requires an estimate of cost of capital in order to make a decision.

6. Cannot be used in situations where sign of the cash flows of the project change more than once during project’s life.

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Reinvestment Rate Assumption

• In slide no. 26 the last difference points towards an important assumption built into the three capital budgeting tools. – NPV: The NPV technique assumes that cash inflows are

reinvested at the cost of capital (i.e. the same rate by which they were discounted).

– IRR: The IRR technique assumes that cash inflows are reinvested at IRR.

– MIRR: The MIRR technique assumes that cash inflows are reinvested at the cost of capital.

Pg. 346

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Which Reinvestment Rate Assumption is better?

• Obaidullah Jan at accountingexplained.com states that,

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Key differences between NPV, IRR and MIRR

NPV• Calculation

– We determine the PV of future cash inflows and then subtract the initial cash outflow from them to obtain NPV.

• Cost of capital is used as the actual discount rate.

• Projects with positive NPV’s are accepted.

• NPV assumes cash flows are reinvested at cost of capital.

IRR• Calculation

– We calculate the rate at which NPV is zero ‘or’ simply stated we calculate the rate of return on a project.

– IRR is the rate at which PV of cost is equal to PV of future cash inflows.

• IRR is compared with cost of capital to determine if it is feasible to accept the project.

• Projects with IRR > cost of capital are accepted.

• IRR assumes cash flows are reinvested at IRR.

• Calculation– We calculate the terminal value

(TV) by summing up the future value of the cash inflows, compounded at company’s cost of capital then find the PV of the TV.

– MIRR is the rate at which PV of cost is equal to PV of the TV.

• MIRR is compared with cost of capital to determine if it is feasible to accept the project.

• Projects with MIRR > cost of capital are accepted.

• MIRR assumes cash flows are reinvested at cost of capital.

MIRR

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Conclusion

• MIRR is a superior method to the regular IRR as an indicator of a project’s true rate of return.

but,• NPV is better than IRR and MIRR when choosing

among competing projects.

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Conclusion

• Independent Projects– For independent projects, NPV, IRR and MIRR all give the

same result if NPV says accept, IRR and MIRR also say accept and vice versa.

• Mutually Exclusive Projects– For mutually exclusive projects, NPV is the best method

to use because it focuses on maximizing shareholder value.

• Obaidullah Jan at accountingexplained.com states that,

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Conclusion• Mutually Exclusive Projects

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capital budgeting chapter 11. capital budgeting an introduction the word ‘capital’ means...

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